How liquid is the company?
The liquidity of a business is defined as Company’s ability to meet maturing debt obligations and to meet unexpected needs of cash. There are two approaches to answer this question. First, we can look at the Company's assets that are relatively liquid in nature and compare them to the amount of the debt coming due within operating year. Second, we can look at the timeliness with which such assets are being converted into cash.
Current ratio can tell us if the company’s short-term assets are readily available to pay off its short-term liabilities. We have above two liquid ratios, which ratio is a better measure of a firm's short-term position? In some ways, the quick ratio is a more conservative standard. If the quick ratio is greater than one, there would seem to be no danger that the firm would not be able to meet its current obligations The quick ratio measures the ability of a firm to pay all of its current liabilities if they come due immediately. If the quick ratio is less than one, but the current ratio is considerably above one, the status of the firm is more complex. In this case, the valuation of inventories and the inventory turnover are obviously critical
Low values for the current or quick ratios suggest that a firm may have difficulty meeting current obligations, however, are not always fatal. If an organization has good long-term prospects, it may be able to enter the capital market and borrow against those prospects to meet current obligations. And very high current ratio may indicate excessive amount of current assets or inefficient asset utilization by management.
Is not necessary if the current ratio is 1 mean company's current assets can meet all of its current liabilities. In fact, Investors and analysts look at a company as a going concern. It's the time it takes to convert a company's current assets into cash to pay its current obligations that is the key to its liquidity. In a word, the current ratio can be "misleading." Therefore, Investors and analysts should take the second approach into their mind to know if the company is liquid or illiquid.
The Company that has zero or negative working capital has no current asset/liability margin of safety, a weaker current ratio, and less working capital exist
Defensive-Interval Ratio, the liquidity position of a firm should be examined in relation to its ability to meet projected daily expenditure from operations as the below formula
The defensive interval ratio measures the time
that the Company can operate on present cash without resorting to next year’s
income or revenue. The defensive-interval ratio is used more common for management
This approach expresses the length of time (in days) that a company take to sell inventory, collect receivables and pay its accounts payable. This can be measured by the below formula for cash conversion cycle.
The shorter days inventory outstanding, the better indicator for company to convert but If Days Inventory Outstanding ratio sharply trends up (rapidly increasing trend) may indicates to decreasing demand for a company's products and obsolescence of inventory may be exist in its warehouse. However sharply trends down in DIO may indicate to the company does not have ability to produce or sale enough volume in the market. The below formula show how to compute the days inventory outstanding
A lower inventory turnover, the longer day’s inventory outstanding that can mean some old inventory is on the books that being used. Holding inventory costs money-it involves the cost of storage, pupilage, and obsolescence.
Average collection period measure used to quantify company’s effectiveness in extending credit as well as collecting debts. The receivables turnover ratio is an activity ratio, measuring how efficiently a firm uses its assets too. A high average collection period ratio implies that company should re-assess its credit policies in order to ensure the timely collection of imparted credit that is not earning interest for the firm. Sharply decreasing trend in average collection period could indicate an increasingly competitive product, which allows a company to tighten its buyers' payment terms. The average collection period is computed by the following formula
Very long collection period will indicate to either poor credit selection or an inadequate collection effort, the liquidity position will be adversely effected, there will be likelihood of a large number of accounts receivables becoming bad debts
The shorter average payment period, and the better indication. Average creditor period measures how long it takes the company to pay its current liabilities very long period may give a bad indication of Company’s capability to pay on time, loss any potential cash discount, and may lead Company to have constrained contract with suppliers.
If the average payment period is longer than collection period and days inventory outstanding, means that cash is being tied up in inventory and receivables and used more quickly in paying off trade payables. If this circumstance becomes a trend, it will reduce, or squeeze, a company's cash availabilities, means Company will be less liquid because the bills are coming due faster than company’s generation of cash. Suppliers prefer to be paid bills with cash more than with working capitals.
As a whole, a shorter Cash Conversion Cycle means greater liquidity, which translates into less of a need to borrow, more opportunity to realize price discounts with cash purchases for raw materials or goods.